One of the biggest economic stories over the past six months has been the outsized growth of inflation after a long slumber. This has caused the Federal Reserve to raise the Federal Funds rate in order to slow the economy and get inflation back under control. The mortgage banking sector, which feasted on easy refinancings during 2020 and 2021, is now experiencing a sharp slowdown.
In light of these changes, let's see how one of the biggest mortgage originators, UWM Holdings (UWMC 2.44%) aka United Wholesale, is faring.
The Fed is the cloud over the mortgage sector
While the Fed only started hiking rates in March, the market started increasing interest rates long before that. Since the beginning of the year, the average 30-year fixed-rate mortgage has increased by about two percentage points, to 5.27%.
Mortgage originators generally work with three types of loans: Purchases, rate/term refinances, and cash-out refinances. Purchase activity is less sensitive to interest rates -- if a homeowner is relocating, they'll need to buy a house with less regard for what the rate is. Cash-out refinances are less sensitive as well -- if a borrower is using the equity in their home to pay off credit card debt that costs 19%, it still makes sense to take out a less expensive-by-comparison home equity loan.
Rate/term refinance loans, where the borrower refinances a high-rate loan with a lower-rate loan, don't work in a rising rate environment. No one is going to ditch a 3% mortgage to take out a 5% one. This evaporation of rate/term refinance activity is the key factor in understanding what's going on with the originators.
Like most mortgage originators, United Wholesale has seen volumes and gain on sale fall. This means that originators are doing less business and making less on that business than they did before. In the first quarter of 2022, origination volume fell by 21% to $38.8 billion compared to a year ago. Gain on sale margin (in other words, the gross profit margin on the loan) fell from 2.19% to 0.99%. Over the past year, purchase activity went from about 25% of the mix to about 50%. Purchases did increase -- however, refinance activity fell by 47%.
Mortgage servicing is helping offset the decline in lending activity
The bright spot in the mortgage business has been mortgage servicing, which is one of the more unusual assets out there. A mortgage servicer administers the loan on behalf of the ultimate investor in the loan. The servicer collects the payments, forwards the owed principal and interest to the investor, ensures property taxes and insurance are paid, and works with the borrower if they get in trouble and miss payments.
The servicer gets 0.25% of the loan as compensation for performing these duties. In a rising rate environment, the chance of that loan getting refinanced falls, since rate/term refinances no longer make sense. This means that the servicer expects to get that servicing payment longer, and that makes the asset worth more.
In UWM Holdings' first quarter, increased servicing income and the increase in the modeled value of the portfolio helped offset loan production income, which fell by 65% due to falling volumes and profits per loan. The mortgage industry is one of those businesses that is really held hostage to changing interest rates, and the volatility in earnings can only be managed.
UWM Holdings is trading at 9.5 times expected 2022 earnings per share, which is about right given that this should be the low point in earnings for the sector. The stock has a dividend yield of 10.6%, and the dividend is still well-covered ($0.10 dividend versus $0.22 earnings per share). While it is too early to start getting bullish on the sector, the yield does give investors a reason to stick around.